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Center-left and populist governments’ hegemony in Latin America for most of the last decade now seems to be coming to an end, with center-right parties rising to power in Argentina, Brazil, Guatemala, Paraguay, and Peru.

We should not be surprised that Latin America’s “red tide” is receding. Historical evidence from the last 40 years shows that political cycles within the region are highly synchronized, and tend to reflect economic booms and busts.

Author

From 1974 to 1981, Latin America’s economy grew at an average annual rate of 4.1%, compared to its annual 2.8% historical average, owing to the 1970s oil-price spike. Petrodollars flooding into the region financed huge public-spending increases and real-estate booms, and fueled an economic bonanza that propped up the continent’s military dictatorships. At the time, authoritarian regimes took credit for the economic boom, because they had reestablished stability and order on the continent.

But this period turned out to be the proverbial calm before the storm. The party was cut short in the early 1980s, when then-Federal Reserve Chairman Paul Volcker took away the punch bowl, by engineering a sudden interest-rate hike to stem inflation. The “Volcker shock” created a triple whammy: the US entered a deep recession; commodity prices plummeted; and Latin America’s capital inflows abruptly reversed, shifting toward US dollar-denominated instruments that offered better yields.

What followed was a “lost decade” of economic depression, stagnant growth, and currency, debt, and banking crises, as Latin American countries’ output contracted or collapsed. This severe downturn created widespread social discontent, and with the fall of the Berlin Wall and the end of US support for military regimes in the region, every Latin American dictatorship except Cuba’s was upended.

For the most part, center-right, democratically elected governments replaced the military dictatorships, and they exchanged the previous economic paradigm – import substitution, state intervention, and overregulation – for the Washington Consensus, which called for fiscal discipline, price stability, trade and financial liberalization, privatization, and deregulation.

By the early 1990s, the 1989 Brady Plan had resolved Latin America’s debt crisis by providing debt relief in exchange for economic reforms, and interest rates in the US had fallen. Foreign capital flooded in again, and the new consensus view was that bond-driven capital inflows would impose market discipline on Latin America’s historically profligate governments, because, presumably, only credit-worthy agents would be able to borrow. Another bonanza ensued, which Latin American policymakers at the time attributed to the Washington Consensus.

Democracy, together with sensible and credible economic policies, seemed to have finally done the trick. But then came the 1997 Asian financial crisis and the 1998 ruble crisis, in which the Russian government defaulted on its debt. Capital fled emerging markets, sending Latin American countries into another nosedive and resulting in economic depression and more currency, debt, and banking crises.

In the early 2000s, Latin America’s economic malaise again gave rise to social discontent, and center-right governments started to fall like dominos, to be replaced by center-left – and, in some cases, populist – administrations.

The new center-left governments, unlike their populist peers, did not repudiate previous commitments to fiscal discipline, low inflation, and open markets. Rather, they built lavish social-welfare and economic-redistribution programs on top of those commitments. This was possible only because of the boom in commodity prices that began in 2003, and the surge in capital inflows until 2012, as developed-country investors searched for yield in the wake of the 2008 global financial crisis.

Once again, high commodity prices and cheap, abundant capital had fueled a decade-long economic boom. And once again, governments in the region attributed their economic success to the reigning paradigm, which this time combined economic orthodoxy with redistributive policies. What’s more, center-right governments had peacefully transferred power to the newly elected center-left governments, which led many people to believe that this time would be different.

They were wrong. Starting in 2012, Latin American economies cooled significantly, owing to the European debt crisis, China’s slowdown, collapsing commodity prices, and capital flight from emerging markets, as rattled investors sought refuge in safe assets. Some Latin American countries faltered, and others fell into deep recessions.

Latin American governments had again convinced not only themselves, but also voters, that their policies were behind the previous boom. When voters’ expectations clashed with the new socioeconomic reality, they took to the streets to protest. Corruption scandals in some countries added fuel to the fire, and a new crop of center-right governments was elected.

Latin America’s 40-year history of political swings between center-right and center-left governments is evolutionary: each new stage builds upon the previous one. Much like creative destruction, evolution preserves what works, discards what does not, and sometimes adds new, disruptive features.

Assuming this pattern holds, what can we expect from the new crop of mostly center-right, mainstream Latin American governments?

Most likely, they will continue the evolutionary process, by preserving some of the basic Washington Consensus tenets, while pursuing new redistribution policies when feasible. But resources will be scarce, so they will need to redesign social-spending programs and infrastructure projects to maximize efficiency and get more bang for their buck. I call this new paradigm “intelligent austerity.” If Latin American governments implement it successfully, they truly will deserve to claim credit for the economic gains that result.

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Imagine that the Brazilian economy were growing at robust rates, as in 2010. Try to imagine, too, that the Petrobras corruption scandal had never seen the light of day. Finally, go back to the time when former President Dilma Rousseff still enjoyed broad popular and congressional support. In short, imagine that Brazil were not undergoing a deep economic and political crisis. Would you still support Rousseff’s impeachment?

If the answer to this question is no, then clearly something has gone wrong in Brazil. Why? Because Rousseff was not removed over her administration’s economic mismanagement. Neither was she ousted over her involvement in corruption scandals, kickback schemes or obstruction of justice in the Petrobras case, as the evidence to corroborate these charges is nonexistent. The truth of the matter is that Rousseff was ousted over having overseen two types of allegedly unlawful budgetary maneuvers: (1) “pedaladas fiscais,” the delay of repayments to state banks intended to mask the fiscal deficit, and (2) issuing decrees to open supplementary lines of credit without congressional approval.

Let’s begin by looking at the legal framework. In Brazil, the president can only be removed from office via impeachment—revoking the popular mandate that elected her in the first place—when there is evidence that she actively committed a so-called “crime of responsibility.” This is clearly stated by article 85 of the Brazilian Federal Constitution. Crimes of responsibility are defined exhaustively by Law 10179/50 and are not open to interpretation by extension or analogy.

While there exists a legitimate debate about whether the budget tricks Rousseff was accused of truly constitute impeachable offenses, the fact is Brazil’s Supreme Court laid the matter to rest this past April—before the case was tried in the Lower House but after a special commission recommended impeachment—when it denied the attorney general’s motion to nullify the impeachment case on due process grounds. The Supreme Court does not have the authority to rule on the political merits of an impeachment, but it does have the last word on technical and procedural matters. Even though it has been argued that neither fiscal “peddling” nor the unauthorized decrees can be unambiguously considered impeachable offenses and therefore that the removal may have been unconstitutional, by letting it run its course the Supreme Court effectively ratified the formal legitimacy of the impeachment trial.

Formal legitimacy notwithstanding, the process in question may still have been tainted by illegitimacy of origin. Indeed, the case has all the markings of an impeachment born out of a political decision to sack a highly unpopular president that had lost parliamentary majorities, incapable of governing a country mired in a deep economic crisis and unwilling to halt the criminal probes weighing on her accusers. Once this decision was made, what followed was simply the search for a pretext that would comply with the formal requirements of an impeachment. The budgetary irregularities that officially led to Rousseff’s downfall likely would never have seen the light of day had the economic and political context been different—especially as this sort of creative accounting has been standard in all of Brazil’s past administrations.

In other words, formal devices were used to recreate the consequences that low public approval and/or the loss of a congressional majority would have in a parliamentary regime. In the end, this amounts to a de facto “parliamentarization” of a presidential system. What’s wrong with that? According to the Brazilian Constitution, neither low public approval nor the loss of a congressional majority constitute impeachable offenses. Unlike the vote of no-confidence or a censure motion—which are features of parliamentary systems—impeachment is a legal procedure, not a political one.

The question we should ask ourselves is whether this practice of de facto “parliamentarizing” presidential systems is truly healthy for democracy. One may think that what Brazil needs is a switch to a parliamentary regime de jure. However, it has been well established that the state of the economy strongly influences electoral results, such that high economic volatility translates directly into high political volatility. In light of the elevated structural economic volatility to which both Brazil and much of Latin America are subjected to—because these economies are exposed to commodity price fluctuations and other external shocks to a greater extent than countries in other regions—parliamentarism might deliver even more unstable politics than the current system.

Which means that, at least for Brazil, presidentialism may be the most sensible choice. But if so, then we must abide by presidentialism’s rules of the game, both formally and in spirit, even if at times they operate against our best interests or we wished they were different. Otherwise we risk making a mockery of institutions and, as the saying in Spanish goes, “he who plays with fire, eventually gets burned.”

For the better part of the past decade, close to 80 percent of countries in Latin America were ruled by center-left and populist governments. However, this hegemony seems to be coming to an end, with center-right parties recently rising to power in Argentina, Brazil, Guatemala, Paraguay, and Peru. Should this come as a surprise? The short answer is no.

A longstanding literature in political science research has documented the existence of an economic vote (Lewis-Beck and Stegmaier, 2000). Namely, substantial evidence reveals voters in democratic countries systematically reelect incumbent governments in times of economic boom and oust them in times of economic slowdown, recession, or crisis.

So the state of the economy influences our political choices. At the same time, economies today are more interconnected than ever before. It follows that countries with synchronized business cycles should display synchronized political cycles as well (Kayser, 2009). To the extent that output fluctuations in commodity-exporting Latin American countries are to a large degree driven by common external factors (Calvo, Leiderman, and Reinhart, 1993; Izquierdo, Romero, and Talvi, 2008), economic booms and busts should then give rise to common political cycles.

1.2 Lessons of Modern History

In this essay, we provide 40 years of historical evidence that lend support to the preceding hypothesis–namely, that political cycles in Latin America are highly synchronized, mirroring economic booms and busts largely driven by common external factors.

1974-1989

The period between 1974 and 1981 was an expansionary one for Latin America. The region grew at an annual rate of 4.1 percent, compared to a historical average of 2.8 percent per year. When the price of oil rose sharply in the 1970s, the resulting “petrodollars” were recycled to emerging economies–and in massive amounts to Latin America–in the form of bank lending. These inflows financed huge increases in public spending and real estate booms across the board, fueling an economic bonanza that propped up the military dictatorships plaguing the continent. At the time, the reestablishment of stability and order by authoritarian regimes was credited with bringing about the economic boom.

And then came the “Volcker shock” as the U.S. Federal Reserve engineered a sudden hike in interest rates to 20 percent in order to defeat inflation, which at the time hovered at around 15 percent. This created a triple whammy for Latin America: the U.S. went into a deep recession, commodity prices plummeted, and capital inflows to the region came to a sudden stop and began flooding out of the region, attracted by handsome yields offered by U.S. dollar-denominated instruments. The result was a “lost decade” of economic depression and stagnant growth, with many countries suffering output contraction and collapse, along with currency, debt, and banking crises.

The political mirror image of the severe economic downturn and widespread social discontent from 1982 to1989–aided in the late 1980s by the fall of the Berlin Wall, the end of the Cold War, and the end of U.S. support for military regimes in the region–was the eventual toppling of every dictatorship in the region (except Cuba). These were replaced by democratically-elected governments, mostly to the center-right of the political spectrum, which in turn swapped the prevailing economic paradigm of import substitution, high government intervention, and overregulation for the Washington consensus: fiscal discipline, low inflation, trade and financial liberalization, privatization, and deregulation.

80% of LAC governments were military dictatorships
(1974-1989)

1990-2003

In the early 1990s, with newly democratically-elected governments installed, the debt crisis resolved through the Brady plan, and the return of low interest rates in the U.S., Latin America was again flooded by foreign capital–this time, mostly in the form of public and private sector bond lending. The consensus at the time was that these bond-driven capital inflows would bring market discipline to an ever-so-profligate region (i.e., only credit-worthy agents would be able to borrow). The ensuing bonanza was interpreted by many as definitive proof of the might of the Washington consensus policies. The combination of sensible and credible policies with democracy seemed to have finally done the trick.

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And then came the Asian crisis of 1997 and the Russian default of 1998, and the huge flight of capital from emerging markets that sent Latin American countries into another nosedive. Once again: recession, depression, and wholesale currency, debt, and banking crises.

By the early 2000s, with economic malaise and social discontent in high gear, center-right governments started to fall like dominoes and were replaced by center–left–or, in some cases, populist–governments in most of Latin America.

70% of LAC governments were center-right (1990-2003)

2004-2014

The new crop of center-left governments did not repudiate the previous commitment to fiscal discipline, low inflation, and open markets. Rather, they built on top of it and enacted massive social redistribution programs (mostly targeted to the very poorest). These programs could only be financed owing to booming commodity prices–since 2003–and to a surge in capital inflows that peaked in 2011, as investors in developed countries searched for yield. Once again, high commodity prices and cheap and abundant capital fueled a decade-long economic boom. Once again, governments attributed their success to the policies of the reigning paradigm, one that–in this case–combined economic orthodoxy with social redistribution.

And then came the Eurozone crisis and a severe economic slowdown in China, a collapse in commodity prices, and capital flight from emerging markets as investors sought refuge in safe assets. Starting in 2012 Latin America cooled off significantly, with some countries faltering and others falling into deep recessions. After a decade of stellar growth and bright expectations, governments had willfully lulled themselves and voters into thinking their own actions were behind the boom. Dashed expectations turned into social discontent and resulted in massive street protests convened through social media. In some countries, corruption scandals added fuel to an already-sweltering fire. This malaise within Latin America has arisen at a time when the foundations of the liberal world order are being weakened by secessionist, nationalist, isolationist, and populist movements throughout the U.S. and Europe.

80% of LAC governments were center-left or populist (2004-2014)

The political mirror image of this socioeconomic slump has been a return to center-right governments. Upon closer inspection, what the region is really witnessing is a repeat of past cycles: a repudiation of incumbents, regardless of their politics. It is only because the 2000s were dominated by left-of-center and populist governments that we are now seeing a swing to the right.

1.3 What’s next?

The history of political cycles and paradigm shifts just described–from center-right to center-left and back to center-right–can be said to be evolutionary, constructed out of building blocks, with each new stage building on top of the previous one. Much like creative destruction, evolution is all about preserving what works, discarding what doesn’t, and adding new, sometimes disruptive features.

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By contrast, populism is about regime change: revolution, not evolution. Populist governments repealed the Washington consensus in favor of fiscal profligacy, high inflation, and extensive government intervention. Instead of espousing sensible redistribution policies such as conditional cash transfers (which aim to build human capital in order to empower the poor), populist governments redistributed wealth through what were essentially handouts that were used as a means for gaining and preserving political power. As populist regimes fail and are replaced by mainstream governments, the region is going to witness a counterrevolutionary paradigm shift rather than an evolutionary shift. The best example of this phenomenon is the end of Kirchnerismo and the dawn of Mauricio Macri’s Argentina.

What policy options might the new crop of (mostly center-right) mainstream governments adopt in these times of fiscal hardship? A return to early-1980s or late-1990s-style fiscal austerity and monetary tightening seems unlikely. Instead, the new paradigm will continue to build upon what came before, preserving some of the basic tenets of the Washington consensus as well as–when feasible–the social redistribution policies enacted by center-left governments. But since resources are going to be scarce, social spending programs–and, incidentally, also infrastructure spending–will have to be redesigned with efficiency in mind, to get more bang for the buck. We have termed this new paradigm intelligent austerity (Talvi, 2016).

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The debate about public policies for development has focused on defining the best interventions to promote growth and inclusion. At the same time, less emphasis has been put on analyzing the capacities of government agencies and institutions to design policies and put them into practice. The recently released 2015 Economy and Development Report (RED 2015) by the Development Bank of Latin America (CAF) seeks to contribute to the study of the capacities of the state to improve the effectiveness of public interventions and promote development in Latin America. Successful interventions require a motivated and able bureaucracy as a crosscutting component throughout the policy production cycle; effective public procurement systems; citizen participation to strengthen accountability and improve the provision of public services; and the establishment of monitoring and evaluation schemes aimed at translating experience into knowledge and learning to increase the effectiveness of the entire process.

On April 21, the Brookings Global-CERES Economic and Social Policy in Latin America Initiative (ESPLA) and the Development Bank of Latin America (CAF) co-hosted Pablo Sanguinetti, chief economist at CAF, for a short presentation of the report. Following Sanguinetti’s remarks, Matthew M. Taylor, associate professor at American University, and Jorge Luis Silva Mendez, public sector specialist at the World Bank, discussed the topic. Elaine Kamarck, founding director of the Center for Effective Public Management and senior fellow at the Brookings Institution,moderated the discussion.

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Sub-Saharan Africa’s GDP growth forecasts are down. In its latest forecasts of the region’s economies, the IMF revised its 2016 growth estimates down to 3.0 percent from 4.3 percent six month ago (Figure 1). The last time the region achieved a similar growth rate was in 1999 (2.8 percent).

Importantly, the expected slowdown largely reflects the impact of more difficult external economic environment on African economies and, in particular, the effects of a sharp drop in commodity prices, the slowdown in China, and of tighter financial conditions.

Figure 1. Sub-Saharan Africa real GDP growth forecasts

The lower growth forecasts are on the back of a long robust growth period in the region. Between 2004 and 2011, sub-Saharan Africa experienced 6.2 percent growth. Since 2012, however, growth in the region slowed down to 4.5 percent between 2012 and 2015. Africa is not alone, though: This pattern of boom and subsequent slowdown was observed in every emerging region in the globe. This doesn’t mean that these changes are insignificant, though. If the IMF forecasts for 2016 materialize, sub-Saharan Africa will experience a growth reversal of 2 percentage points in 2012-2016 compared to 2004-2011.

To answer this question, the Africa Growth Initiative has partnered with Brookings-CERES Economic and Social Policy in Latin America Initiative (ESPLA) to study the role of external factors in explaining output fluctuations in sub-Saharan Africa. The analysis focuses on the seven largest economies (SSA-7), which account for three quarters of sub-Saharan Africa’s GDP (Angola, Ghana, Kenya, Nigeria, South Africa, Ethiopia, and Tanzania). For this more detailed analysis, see here.

The key, initial findings of the study are:

Almost half of sub-Saharan Africa’s output fluctuations since 1998 can be explained by a small set of external factors—namely, GDP growth in G-7 countries, GDP growth in China, oil and non-oil commodity prices, and borrowing costs for emerging economies in international capital markets.

Figure 3 illustrates that this small set of external variables help explain about 44 percent of sub-Saharan Africa’s output variance. As a result, both the boom experienced between 2004 and 2011 and the sharp deceleration observed since 2012 can, to a large extent, be attributed to significant changes in the external environment, from extremely favorable in the former period to more adverse in the latter.

Figure 3. Sub-Saharan Africa’s Business Cycle: The Role of External Factors (annual GDP growth, in real terms, for SSA-7)

Data sources: IMF and authors’ calculations.

Note: Predicted GDP growth corresponds to the prediction of a vector error correction model using only the observed external factors from Q1.1998 to Q4.2014. For technical details, see “Booms and Busts in Latin America: The Role of External Factors” (Izquierdo, Romero and Talvi 2008).

Key downside risks for sub-Saharan Africa’s growth include a sharp slowdown in China’s growth, a further decline in commodity prices, and a tightening in international financial conditions for emerging economies. Whereas permanently lower commodity prices and tighter financial conditions for emerging economies would only have temporary effects on sub-Saharan Africa’s output growth, a permanent Chinese slowdown would have a larger and persistent effect, as seen in Figure 4.

Data sources: IMF and authors’ calculations.
Note: The baseline scenario corresponds to the prediction of the model when external factors are assumed to evolve according to market expectations. The China shock is a reduction in growth from 6.5% to 4%; the financial shock is an increase of 300 bps above baseline EMBI+ levels; the commodities shock is a price fall of 20% below baseline levels; the combined shock combines all of the above simultaneously.

Given the importance of external factors in explaining output fluctuations in sub-Saharan Africa, a key policy recommendation is that in order to properly evaluate a country’s fundamentals, policymakers should work with structural indicators of sustainability. For instance, the structural fiscal and current account balances are the fiscal and current account positions that would result when the key external drivers of the business cycle of sub-Saharan Africa such as commodity prices are computed at their long-run values.

Fiscal sustainability refers to the ability to run fiscal deficits and pile up public debt without compromising a country’s perceived solvency. Figure 5 shows that during the boom period (2004-2011), the observed fiscal balance was consistently above the structural fiscal balance and thus conveyed the impression that the fiscal position was stronger than it actually was. As commodity prices declined and output growth decelerated during the cooling-off period (since 2012), the observed fiscal balance began moving towards the structural fiscal balance, revealing that the underlying fiscal position was actually weaker than the observed one.

Figure 5. Structural Fiscal Balance (% of GDP)

Data sources: IMF and authors’ calculations.
Note: The structural fiscal balance is calculated by performing a linear estimation on observed fiscal revenues between 1998 and 2003, before the boom began, and extrapolating from then on.

External sustainability refers to the ability to sustain excess spending over income with external capital inflows. Figure 6 shows that during the boom period (2004-2011), the observed current account balance was consistently above the structural current account balance and thus conveyed the impression that the external position was stronger than it actually was. As commodity prices declined during the cooling-off period (since 2012), the observed current account balance began moving towards the structural current account balance, revealing that the underlying external position was actually weaker than the observed one.

Figure 6. Structural Current Account Balance (% of GDP)

Data sources: IMF and authors’ calculations.
Note: The adjusted current account balance is calculated by using the average of export and import prices observed between 1992 and 2003, before the boom began.

These findings shed some light on the “Africa Rising” narrative—the recent economic boom cycle in sub-Saharan Africa. In particular, they highlight the important role of external factors, which accounted for almost half of the region’s output fluctuations. They also point to the need for policymakers to be cautious in boom periods and rely on structural economic indicators that are less sensitive to the boom-bust cycle of external factors such as commodity prices.

In Foresight Africa: Top Priorities for the Continent in 2016publications, we have highlighted some policy responses to changes in the external environment. These policy responses include a mix of short-term and medium-term measures such as fiscal, monetary, and exchange rate policy to absorb external shocks as well as increased domestic revenue mobilization and structural reforms to diversify African economies away from commodities.

Indirectly, the findings above emphasize the important role of domestic policies in explaining Africa’s growth. If external factors explain half of output fluctuations, then it is crucial to make sure we get “the other half” of domestic factors right. Now that we are in a bust cycle, the political appetite for policy reforms should be higher. Now is the time for implementation.

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The global trading system is undergoing fundamental changes. While World Trade Organization members continue to work towards an agreement tailored to the exigencies of 21st century commerce, countries are focusing their attention on new regional trade and investment initiatives. In particular, some mega-regional trade agreements currently under negotiation have the potential to reshape the global trade landscape in years to come. As this new architecture emerges, the Western Hemisphere finds itself without a coherent vision to promote integration. Many observers believe that political differences within the region stand in the way of region-wide initiatives. However, the emergence of new drivers of trade integration beyond tariffs and other traditional market access issues—in particular, in the area of trade facilitation measures—present opportunities for a renewed strategic vision to promote integration in the Americas. The moment is therefore right for a dialogue on the future of trade in the Americas to address key challenges and discuss policy frameworks that could strengthen the region’s economic connectivity in a pragmatic yet powerful way.

On April 12, the Brookings Global-CERES Economic and Social Policy in Latin America Initiative (ESPLA) and the Integration and Trade Sector at the Inter-American Development Bank hosted a panel discussion on the future of trade in the Americas.

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The global trade regime is undergoing fundamental changes. While World Trade Organization (WTO) member countries continue to work towards an ever elusive agreement, regional initiatives—most notably mega-regional agreements—have emerged as the focal point of countries’ efforts to advance a trade agenda that responds to the realities of 21st century commerce. These mega-regional deals have the potential to reshape the global trade landscape, bringing about important changes both in the geography of integration as well as in its scope and depth. As this new architecture emerges, the Western Hemisphere finds itself without a coherent vision to promote its own integration. This needs to change if the region is to make the most of its trade relations in a challenging global environment.

While naysayers may contend that intractable political differences stand in the way of region-wide initiatives, we believe the emergence of new drivers of trade integration beyond tariffs and other traditional market-access issues presents actionable strategic options to integrate the Americas. We argue for a region-wide integration initiative based on two pillars: (1) promoting convergence of existing free trade agreements (FTAs), and (2) implementing an ambitious hemispheric-wide trade facilitation agenda. Critically, these policies would address two prominent obstacles to trade in the region while removing the need to embark on the challenging road of new region-wide FTA negotiations. We see in this proposal a timely convergence between what is politically feasible and what is economically necessary to kick-start integration in the region. The time is ripe for a leap forward: a Trans-American Partnership (TAP), an initiative tailored to the Americas’ particular challenges and diverse policy frameworks that would deepen integration in the Americas in a pragmatic yet powerful way.

I. New emerging dynamics in the global trading system

We begin this essay by recognizing some new drivers of trade integration at the global level. The existing network of FTAs is relatively comprehensive and has successfully dismantled traditional barriers such as high tariffs and import quotas. Therefore, any additional agreements that address these issues are subject to diminishing returns. As a result, countries are looking to alternative policy mechanisms to more effectively deepen economic integration. These strategies include addressing some prominent remaining gaps in the universe of traditional FTAs, enhancing the scope of traditional agreements to incorporate the so-called beyond-the-border regulatory issues, improving the efficiency of the existing network of FTAs through harmonization and convergence of overlapping rules, and addressing operational bottlenecks facing firms through trade facilitation initiatives. We will now review each of these new key drivers.

First, there remain significant “missing links” in the current global trade architecture, as major trading partners still lack bilateral FTAs. These gaps exist among developed nations (e.g., the U.S., EU, and Japan[1], large developing countries (e.g., Mexico, Brazil, China, and India), and between developed and developing countries (e.g., the US and Japan with China). Second, due to the growing importance of regional and global value chains, trade deals are increasingly going beyond market access to include beyond-the-border issues such as regulatory barriers to trade, services, investment, and intellectual property, among others. Both of these strategies would require formal trade negotiations, which inevitably pose thorny political economy problems.

However, this is not necessarily the case for two additional drivers of global commerce: convergence of trade agreements and trade facilitation measures. First, the current trade architecture built over the last two decades has resulted in multiple overlapping FTAs, each with its own set of rules. Harmonizing certain elements of these agreements—especially those that concern rules of origin (RoO)—would reduce transaction costs and increase firms’ options for sourcing inputs, allowing countries to take full advantage of lower tariffs and amplifying the economic impact of trade agreements. This is the essence of FTA convergence. Second, trade facilitation measures that address the logistical costs incurred by exporters and importers are becoming critical features of modern trade policy. Trade facilitation refers mostly to “soft” infrastructure (policies and regulations), though it can be extended to “hard” infrastructure as well (e.g., roads, ports, and airports). Some good examples of soft trade infrastructure policies—our focus in this paper—are the harmonization and standardization of procedures for moving goods through customs, the implementation and interoperability of single windows for foreign trade, the use of authorized economic operator programs, and coordinated border management initiatives.[2] These last two drivers, convergence and trade facilitation, are much less politically charged than traditional trade negotiations and thus can be implemented more easily.

The trade mega-agreements under negotiation today clearly underscore the importance of these new drivers. The Trans-Pacific Partnership (TPP) and the Trans-Atlantic Trade and Investment Partnership (TTIP)—as well as the often overlooked Pacific Alliance (PA) in Latin America and the Caribbean (LAC) and the Regional Comprehensive Economic Partnership (RCEP) in Asia—hold the potential to fill major missing FTA links between the United States and Japan and between the United States and the European Union, respectively. At the same time, a large number of countries in the TPP (as well as in the PA and RCEP) already have FTAs in place with each other, meaning that, once implemented, the TPP will promote convergence by harmonizing existing rules and concessions negotiated in prior agreements. Finally, these new regional initiatives place particular emphasis on enhancing connectivity through a variety of trade facilitation procedures, in many cases going well beyond what has been achieved at the multilateral level.

Countries throughout Latin America are also taking advantage of these new dynamics in the global trade architecture. The Pacific Alliance—a recent sub-regional initiative between Chile, Colombia, Mexico, and Peru—is a good example of how to promote convergence of existing FTAs. The four members already had FTAs in place with each other that included tariff concessions covering most of their bilateral trade flows. However, the existence of different rules of origin limited firms’ ability to source inputs from other Pacific Alliance countries and still qualify for preferential tariffs. To address this issue, the Pacific Alliance bloc negotiated a new RoO regime that allows for accumulation among all members. They are now focusing their efforts on trade facilitation measures, such as the interoperability of national single-window systems and mutual recognition agreements for authorized economic operator (AEO) programs in order to streamline export and import procedures, among others. Furthermore, the Pacific Alliance and Mercosur have shown political interest in exploring ways to advance integration between the two blocks. If successful, this move will help bring Brazil and Mexico—the region’s two economic giants—closer together and put recent trade disputes behind them. Similar efforts are also being prioritized in Central America and the Caribbean. These and other initiatives show that governments across LAC have already embraced pragmatic policies to enhance connectivity and make the most of their existing trade agreements. However, what is lacking is a regional framework that builds on this momentum and channels these initiatives into a coherent integration strategy for the Americas. Such a strategy is necessary if LAC countries are to make the most of the opportunities for integration the current scenario presents.

II. Trade architecture in the Americas: Time for a new Trans-American Partnership [3]

The current trade architecture in the Americas is the product of multiple waves of regional integration starting in the 1960—70s and continuing through the so-called new regionalism of the 1990s and 2000s, which created a complex web of agreements within the region and with extra-regional partners (see Table 1 and Figure 1). While this network of FTAs has generated myriad benefits for the region, it has also resulted in overlapping agreements among subsets of trade partners and unevenness in the coverage of agreements across the region—both of which hinder trade. As a result, the current trade architecture is characterized by two loosely defined groups of countries. The first group more enthusiastically embraced the FTA model during the 1990s and 2000s and is consequently closely linked together and to and the North American market through a series of overlapping agreements (henceforth known as FTA-linked countries). These agreements, often called new generation FTAs, feature a high degree of liberalization and comprehensive rules on beyond-the-border issues. The second group prioritized different integration goals and has consequently developed a less dense network of more limited trade agreements. To be precise, the first group of FTA-linked countries includes partners to the North American Free Trade Agreement (NAFTA), the Central America Free Trade Agreement (DR-CAFTA), and the Pacific Alliance—that is, the United States, Canada, Mexico, Guatemala, El Salvador, Honduras, Nicaragua, Costa Rica, Panama, Dominican Republic, Colombia, Peru, and Chile. The second group includes the remaining countries of the Americas. However, some of the proposals included in this paper—in particular, RoO convergence—could be extended to a larger number of countries linked by more shallow bilateral trade agreements (although this would entail more complex technical and sequential issues for implementation). This extension would be especially relevant for those agreements between Mercosur and the Pacific Alliance countries.

Figure 1. Worldwide FTA network

This current trade regime presents two key challenges for the region: (1) the high costs associated with overlapping FTAs within the first, densely linked group, and (2) the lack of connectivity between this group and the second group. Policymakers throughout the region are well aware of these challenges and are currently working to overcome some of these barriers, as mentioned above. Yet these initiatives, however promising and welcome, fall far short of a comprehensive strategy to eliminate the obstacles implicit in the region’s current trade architecture. In addition, they remain largely decentralized and disaggregated across sub-regions and issue areas, and as a result opportunities to exploit economies of scale and scope are squandered. Recognizing that this hemisphere offers opportunities for greater connectivity, the natural next step is to engage countries in a Trans-American Partnership (TAP), an initiative that can channel the current drivers of integration in the region while taking into account political economy constraints. The proposed TAP would be grounded on two key drivers: (a) convergence of existing FTAs, and (b) trade facilitation to better connect all countries in the Americas regardless of their FTA status. To be clear, this is not a proposal to engage the region in a new phase of full-fledged trade agreements aimed at connecting “missing links” or expanding the agenda to beyond-the-border issues. Instead, it should be seen as a necessary first step towards deeper integration that would maximize the economic gains of the existing, hard-won trade architecture.[4]

Table 1. Canada and the United States’ free trade agreements with Latin America and the Caribbean

FTA convergence

The first policy tier involves promoting the convergence of trade rules among FTA-linked countries, i.e., those countries that already have new generation FTAs with each other. While regulatory convergence encompasses a number of issues, the priority should be to achieve harmonization and cumulation of RoOs. To see why, it is important to look more closely at rules of origin and their role in trade agreements.

The premise of an FTA is to lower (or eliminate) tariffs on goods that originate in countries that are parties to the agreement. All FTAs therefore include explicit and precise criteria that define which goods can be considered products of a member country and are thus eligible for preferences.[5] While necessary, these RoOs also impose hefty costs on firms. First, RoOs limit a firm’s options in sourcing inputs and material from abroad, thereby undermining the creation of regional and global value chains. Secondly, RoOs generate significant administrative and compliance costs. These are not mere rounding errors: Studies have found that RoO compliance costs can amount to as much as 10 percent of total costs for some products.[6]

When a country is a party to multiple agreements with different RoO regimes, the complexity and administrative burden of compliance—and its associated cost—increases exponentially. In addition, multiple RoOs create barriers to trade even among groups of countries that have bilateral FTAs between each country pair by limiting the use of inputs from any given third country. This is precisely what is occurring today among FTA-linked countries, where the existence of multiple and overlapping RoO impedes the development of robust supply chains, as companies are deterred from setting up production in a given country despite the existence of a bilateral FTA due to RoO requirements. The goal of the TAP is therefore to replace the patchwork of RoOs among these countries with a single RoO with full cumulation—that is, one that allows firms in any country to use materials from any of the other countries without jeopardizing preferential access.[7] A single coherent RoO regime for these countries would remove a major barrier to intraregional trade and the emergence of supply chains, allowing the region to reap far greater gains from its existing FTAs.

Trade facilitation

The second policy tier involves ambitious trade facilitation measures to increase trade connectivity in the hemisphere, in particular between FTA-linked and non-FTA-linked countries. Trade facilitation encompasses a wide array of programs and policies designed to address the numerous logistical bottlenecks that create avoidable transaction costs and impede the flow of goods. For the purposes of the TAP, a subset of trade facilitation initiatives that aim to streamline, modernize, and connect countries’ customs operations—often the source of lengthy delays for LAC firms—holds the greatest potential. Such soft infrastructure interventions should include expanding and connecting national single windows for foreign trade, authorized economic operator programs, and other coordinated border management initiatives—measures that are already in place in over a dozen LAC countries.

The TAP would build on this work, improving existing policies and procedures and encouraging coordination among national authorities to enhance their impact on regional trade. For example, cooperation can allow for interoperability of single-window systems, which enables customs authorities to exchange and process information quickly by linking—both technologically and administratively—these systems within the region. Similarly, countries with authorized economic operator programs have the potential to mutually recognize companies’ certified status, expanding the opportunities and benefits for participating firms. Such efforts are already underway at the sub-regional level; for instance, the Pacific Alliance is implementing an interoperability program to link the single-window systems of its four members and is exploring mutual recognition agreements for their respective AEO programs. At the same time, Central America is moving towards an ambitious coordinated border management program to integrate the sub-regions’ customs systems.

While trade facilitation may not make for splashy headlines, it is of vital importance in the current trade environment. Lengthy delays in moving goods between countries generate high costs in the region and undermine firms’ competitiveness in a global economy that demands consistent, just-in-time delivery. A large body of recent empirical work has estimated the positive payoffs of trade facilitation measures that address such delays. For example, an Organization for Economic Co-operation and Development (OECD) report found that streamlining trade procedures has the potential to reduce transaction costs by 5.4 percent;[8] similarly, a 1 percent improvement in trading partners’ export and import procedures—as measured by the Enabling Trade Index, a World Economic Forum index that captures various dimensions of hard and soft trade facilitation policies—can boost bilateral trade by 4 percent.[9] Evidence from the region also supports these findings. In a forthcoming study, the Inter-American Development Bank found that exports in Uruguay would increase by around 6 percent if all shipments subject to physical inspection cleared customs within one day.[10] Recognizing how handsome the rewards can be, the TAP would make trade facilitation a priority.

A crucial feature of trade facilitation is its potential to increase connectivity between economies regardless of tariff rates or the existence (or lack thereof) of an FTA. It thus provides the best and most strategic option for forging closer connectivity between FTA-linked and non-FTA linked countries, thereby encouraging a region-wide integration process. In fact, we are already witnessing the emergence of some measure of political will to increase connectivity in countries without a history of integration agreements. The Pacific Alliance and Mercosur are currently considering ways to promote convergence between the two blocs. Customs cooperation, interoperability of national single-window systems, mutual recognition of authorized economic operator programs, and other advances in soft infrastructure policies can show the way forward. In the same vein, the United States signed a memorandum of intent covering trade facilitation issues with Brazil in 2015 and more recently with Argentina, during the visit of President Obama in March 2016. Trade facilitation has proven to be a potent tool to deepen integration while removing the need for lengthy formal trade negotiations.

The attractiveness of the TAP lies in its relatively low cost, its timeliness, and its ability to strengthen the existing trade network by targeting two critical gaps in the current integration architecture. Rather than starting from scratch, the TAP would build on the hard work of governments in the region over the past few decades. Any further liberalization requiring additional negotiation would be minor. What’s more, unlike its alternatives, the TAP is not contingent on the conclusion of existing negotiations. Some observers argue that the best strategy for LAC countries is to latch onto existing mega-regional agreements such as the TPP. However, this stance implies that countries would have to wait for negotiations to be concluded and agreements to be ratified, and would therefore be shut out of their benefits for the foreseeable future. Finally, the TAP would provide a mechanism to expand and enhance intra-regional supply chains, creating opportunities for far more extensive regional linkages than would be the case if only a handful of additional LAC countries joined the TPP.

III. Final words: Learning from the past, leveraging the present, and looking towards the future

The countries of the Americas have made tremendous strides in opening their markets and integrating into the global economy. Much of this progress has come through FTAs with intra-regional partners, and as a result new drivers of integration mirroring broader global trends have emerged in the region. In response, governments across the Americas—despite having diverse economic and political profiles—have begun to pursue policies that address the key remaining barriers to integration through convergence and trade facilitation measures. Most importantly, the private sector is becoming a critical player in this agenda by employing innovative mechanisms to coordinate action at the regional level.[11]

If countries are already moving ahead on this important agenda, why do we need a region-wide partnership? What is the value added of the TAP over and above the existing unilateral and sub-regional initiatives? Skeptics might worry that trying to forge broader regional agreements may be counterproductive, distracting from the fast progress of like-minded sub-groups such as the Pacific Alliance. We firmly disagree. At a basic level, the TAP would provide a platform to scale up and coordinate existing sub-regional efforts by bringing in new partners and ensuring that various policies have the greatest possible impact on the whole region. These advantages are especially salient in the trade facilitation area, where there exists enormous potential for connecting different projects underway throughout the region. In terms of convergence of overlapping FTAs, we have shown that the rules of origin in existing agreements already share key commonalities that make constructing a unified RoO regime among FTA-linked countries a perfectly attainable goal. In short, we believe that any transaction costs arising from new RoO negotiations pale in comparison to the impact that a unified set of rules would have on intraregional trade and supply chains.

On a more strategic-political level, it is important to forge links among all countries in the region in order to ensure that the budding sub-regional projects do not lock these groups into separate systems at the expense of a more functional regional architecture. A coherent regional strategy that explicitly works both to deepen integration among FTA-linked countries and to maximize connectivity with non-FTA-linked countries is the best way to channel the momentum of diverse sub-regional initiatives towards common regional goals. This shared agenda is not ideological, but rather very pragmatic, in that it leverages the important progress of the past twenty years into a more coherent system that promotes the development of modern, sophisticated regional value chains, while lowering the costs and uncertainties associated with trade. Many of the countries of the region are individually small, but as parts of a larger and more integrated hemispheric economy they can attract investment and participate in globalized supply chains, reaping the benefits from the success of the hemisphere as a whole.

As this proposal involves linking North American and LAC economies, it will naturally conjure up memories of the failed Free Trade Area of the Americas (FTAA). Pessimists may therefore prima facie consider the TAP similarly problematic. Such pessimism, however, would be misguided. The TAP represents a much more pragmatic approach to increasing trade and investment in the Americas; it is a feasible initiative attuned to the region’s political realities and economic needs and to a new emerging global environment of large-scale, continent-wide trade pacts. The FTAA failed at least partly because it attempted to foist a single vision of integration—one with strong ideological undertones—onto an economically, politically, and socially diverse region. By contrast, the TAP project can succeed precisely because it acknowledges the diversity within the Americas and identifies pragmatic yet critically important policies tailored to the specific integration challenges facing the region. If adopted, the partnership will become a stepping-stone to deeper forms of integration in the future. It would comprise 981 million consumers and have a combined GDP of more than $25 trillion (37 percent larger than the EU and more than double that of China). Rather than being a quixotic attempt to forge a shared regional vision, the TAP is a realistic “business plan” for trade in the Americas—one that addresses the most important barriers to regional integration and one that can yield considerable economic gains.

Volpe, Christian. 2016 (forthcoming). “Out of the Border Labyrinth: an Assessment of Trade Facilitation Initiatives in Latin America and the Caribbean.” Washington: Inter-American Development Bank.

[1] The U.S.-Japan gap will be closed by the TPP when ratified, as will the U.S.-EU gap when the TTIP is completed.

[2] Single windows allow traders to electronically submit all documentation related to the regulatory and administrative requirements of relevant government agencies through one single facility and thus also facilitate information-sharing among countries’ customs agencies; authorized economic operators allow customs agencies to pre-certify firms as complying with World Customs Organization security standards, thereby allowing for simplified customs procedures; finally, coordinated border management refers to a broad range of measures to enhance interoperability among government agencies at border crossings. These are but examples of a wide array of trade facilitation measures that can be implemented at the national, regional, or multilateral level.

[3] The original idea on a new Trans-American Partnership (TAP) was put forth by Talvi (2014).

[4] A proposal linking LAC countries with the European Union with similar objectives, although requiring traditional trade negotiations, has been proposed recently by Lagos (2014).

[5] Rules of origin in FTAs take two basic forms. The most common is to specify certain material inputs that must be originating in order for a product to qualify for preferences. This ensures that production all take place in the FTA countries, starting with these inputs and continuing up to the final good. An alternative, complementary form of RoO, is to require that a certain percentage of the value of a product originate in the FTA countries.

[6] Estevadeordal and Suominen (2009).

[7] The goal of establishing a single RoO regime with full cumulation in the tier for FTA-linked countries is facilitated by the fact that the rules in the existing agreements between these countries already share many common features. See Estevadeordal and Suominen (2009).

[11] In this context, it is worth mentioning the role of the Business Council of the Pacific Alliance, launched with the Pacific Alliance, and the Americas Business Dialogue, a hemisphere-wide private sector platform that complements other existing bilateral business dialogues on trade issues launched in 2015 at the Summit of the Americas in Panama. See IDB-ABD (2015).

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Editor’s Note: On April 2-5, 2016, Ernesto Talvi participated in the Latin America Shadow Financial Regulatory Committee (CLAAF), held in Washington, D.C. The committee is composed of a group of prestigious independent Latin American economists, former policymakers, and academics with strong expertise in the field of macroeconomics, banking and finance and whose goal is to identify and analyze challenges and risks for the region. The following document—Policy Statement Number 35—was released at a press conference held at the Center for Global Development immediately following the meetings. It discusses the actions taken so far by the Argentine government and recommends a series of policy actions to establish credibility, modernize the regulatory framework, and boost investment, economic activity, and employment.

In the past decade or so, Latin America has been characterized by two quite distinct groups of countries. On the one hand, countries such as Chile, Colombia, Costa Rica, Mexico, Peru, and Uruguay have expanded anchored on a market-friendly economic model, integrated to international capital markets. On the other hand, with varying degrees, countries such as Argentina, Brazil, Ecuador, and Venezuela have adopted economic models with significant degrees of government intervention and widespread controls on trade and capital flows. Within the latter group, Argentina and Venezuela represented the most extreme version of the neo-populist paradigm.

With the election of Mauricio Macri last December, Argentinians voted to initiate a potentially substantive change in economic policy. The return of Argentina to pro-market policies and to integration to international capital markets is fraught with challenges in terms of reform-strategy design and in terms of implementation risks.

Whether Argentina is successful in its endeavor will likely influence the on-going public policy debates in several other countries in the region. In particular, in view of the mounting economic difficulties in Brazil and Venezuela, Argentina’s experience could be highly relevant.

1. Initial conditions

From the outset, Argentina’s new government faced a complex set of economic imbalances and distortions, including:

(a) A very difficult fiscal situation characterized by a record-high fiscal deficit of the order of 8 percent of GDP, and an unprecedented level of overall public expenditures (at the federal, provincial, and municipal levels) of about 50 percent of GDP in 2015, that doubles the levels observed at the beginning of the 2000s. The sharp increase in public expenditure was mostly reflected in higher public employment and the wage bill, pensions, and subsidies, while public investment remained low and inefficient.

(b) The debt restructuring carried out in 2005 had resulted in a series of lawsuits lost by Argentina in US courts, and ultimately upheld by the U.S. Supreme Court, effectively isolating the country from international capital markets. Lack of access to market-based finance forced the government to rely on monetary financing by the central bank that, in turn, fueled increasing inflation and large losses of international reserves.

(c) The depletion of international reserves had led the previous government to adopt draconian foreign exchange and capital controls that stopped capital inflows and foreign investment almost completely, as the parallel exchange rate was 50 percent to 70 percent higher than the official exchange rate. As the adoption of foreign exchange restrictions proved unsuccessful at stopping the reserve drainage, arbitrary restrictions were imposed on the outflow of dividend payments and on the provision of foreign exchange to pay for imports at the official rate. As net international reserves fell close to zero, the mounting arbitrary restrictions on imports contributed to an already stagnant economy and adversely distorted entrepreneurial and household incentives.

(d) The decision to substitute a fully funded pension system with a pay-as-you-go system facilitated the decapitalization of the State and increased cash flow requirements at the federal government by nearly 4 percent of GDP annually between 2010 and 2015.

(e) Despite an inflation rate between 25 percent and 40 percent per annum between 2008 and 2015, the former government maintained prices of public services almost frozen in nominal terms. Maintaining a price structure that fails adequately to reflect average costs of public-services provision—such as electricity, gas, and transportation—resulted in a dearth of investment in needed infrastructure. Moreover, by compensating operating losses with direct subsidies, the government added a 4 percent of GDP worth of annual deficit to public finances, while the quality of public services provision deteriorated severely.

(f) In the wake of a reversal in the terms of trade experienced by Argentina, as well as other countries in the region, the former government maintained high and unsustainable export taxes that turned many regional productive activities uncompetitive.

2. International context

Argentina’s adjustment will take place facing significant headwinds from the rest of the world. Commodity prices, and in particular agricultural commodities, have fallen sharply and are expected to remain depressed. In particular, the world price of Soy has fallen by nearly 50 percent from its 2012 peak, and future prices through 2019 signal continued weakness, with prices at about the same level as today.

Conditions in world financial markets are also unfavorable. World real interest rates are likely to remain very low and the pace of tightening of U.S. monetary policy has slowed. However, capital flows into emerging markets in general are not expected to recover strongly, and there are further downside risks associated with China’s deceleration. Argentina’s access to capital markets is very uncertain and hinges on the success of its adjustment policies and the return to sustainable growth.

Weak growth of world trade and the crisis in Brazil indicate that external demand will be a drag for Argentina’s growth in the near future. Brazil, Argentina’s biggest trade partner, is suffering its worst recession in decades. Brazil’s GDP fell by 3.8 percent in 2015 and it is expected to fall between 3 and 3.5 percent in 2016. Out of total exports of $68.3 billion in 2014, Argentina exported $13.9 billion to Brazil, followed by China with $4.5 billion and the United States with $4.0 billion. Compared to 2013, this implied a reduction of exports to Brazil by $2.3 billion. Most of Argentina’s exports to Brazil are manufactured goods (vehicles, close to $6 billion in 2014 down from $8 billion in 2013) while exports to other markets are mainly commodities. In addition, the negative effects of the recession in Brazil will affect tourism and capital flows. Thus, the committee believes that Brazil will continue to be a risk factor for Argentina over the short-term.

3. Early decisions

The new administration implemented policies in several crucial areas in the first 100 days, and implicitly revealed a sequencing of reforms that recognizes the constraints posed by the political environment—in particular, its minority stake in Congress.

At the outset, the new administration moved swiftly to remove the toughest foreign exchange restrictions and proceeded effectively to unify the foreign exchange market. Exchange rate unification—which implied a depreciation of around 40 percent of the official exchange rate—appears to have had a limited pass-through to the price level. Indeed, exchange-rate unification had been expected for some time, and there is evidence that the pass-through to prices had already taken place during 2014 and 2015, as the parallel exchange rate had become the relevant rate for price-setting decisions.

The second important area where the new administration acted quickly is that of taxation. In particular, making good on campaign promises, the new administration doubled the non-taxable minimum of the personal income tax, and eliminated all export taxes except for soybean. In the latter case, the elimination of the 35 percent export tax will take place with reductions of 5 percentage points per year starting in 2016. These tax reductions are estimated to add 1.3 percent of GDP to the 2016 fiscal deficit. Additional revenue losses will derive from a Supreme Court decision issued in December by which a significant portion of the tax revenue will be reallocated to provincial governments. Such decision, which was extended by the outgoing government to all provinces by decree, has now been renegotiated to be transferred over a 5-year period.

Partly in connection with the above fiscal measures, the new administration also moved in the direction of adjusting several regulated prices, to remove distortions and restart investments in infrastructure. Regulated prices of energy, public transportation, water, gas, and petroleum have been sharply increased, reducing government subsidies by about 1.5 percent of GDP. The social impact of these adjustments is expected to be largely offset by the previously mentioned tax reductions.

Finally, the government rapidly sought to resolve to outstanding default situation generated by the lawsuits lost by Argentina in U.S. courts and by proceedings outstanding at International Centre for Settlement of Investment Disputes. Agreement was reached with most holdouts, and the government obtained a significant political success in Congress with the abrogation of two laws that impeded the implementation of those agreements. The resolution of the holdout situation is regarded by the government as instrumental in allowing the Argentine economy to regain access to international capital markets. The agreements to settle obligations with holdouts initially imply a new debt issue of $12 billion.

Normalization of relations with the international capital market as well as the International Monetary Fund (IMF) is widely expected to contribute to an improvement in the monetary policy front. While Argentina works towards restoring the credibility of its statistics—in particular, the price level and GDP—the government has announced the intention to focus the role of the Central Bank on gradually reducing inflation and monetary financing of the budget deficit, while reducing its focus on the nominal exchange rate as price anchor. The announced gradual reduction in the monetary financing of the deficit relies on the assumption that the budget deficit will be increasingly financed through debt.

To manage the difficult monetary transition, the Central Bank has relied on a strong program of sterilization through issuance of short-term domestic debt held by the banking system, at interest rates currently running at 38 percent per annum. Sterilization has been necessary not only to respond to the money creation stemming from the budget deficit, but also to absorb the endogenous money creation generated by massive forward exchange contracts entered by the previous Central Bank administration at the official exchange rate.

Although the abovementioned actions cannot at all be characterized as gradual, the government has placed emphasis on announcing that the reduction in the budget deficit and inflation will be gradual. On the fiscal front the government has announced targets for the primary deficit until 2019, without specifying how these targets will be achieved. On the inflation front targets have not been made explicit, other than saying that inflation will decline sharply in the second half of 2016. The adjustments in administered prices and the exchange rate unification have resulted in a monthly inflation rate of about 4 percent in the first quarter of 2016.

4. Challenges and recommendations in light of Latin America’s experience

The success of Argentina’s reform strategy requires building a strong credibility in the policy framework moving forward. In this respect, the committee supports the actions taken so far by the Argentine government to rebuild institutional capacity—such as the reconstruction of a transparent national statistics office and the resolution of the holdouts issue—and to remove severe distortions—such as the adjustments in administered prices. However, and recognizing that these reforms cannot be made overnight, the committee believes that to achieve the credibility needed to boost investment, the government has to move beyond price adjustments and develop new modern and stable regulatory frameworks for public services and transport infrastructure. Modernizing the regulatory frameworks is crucial in order to improve the terms of financing and investment in these sectors.

Also, the committee sees merit in adopting a gradual approach in reducing the budget deficit and monetary financing, but this approach, to be credible, requires a well-crafted and clearly announced plan that is consistent with a reduction in inflation and with the external financing limits that Argentina will most likely face. The importance of credibility should not be played down, as the quality of Argentina’s institutions deteriorated significantly over the last decade.

Adopting a gradual approach regarding the reduction of the budget deficit makes sense as the economy is currently experiencing a moderate contraction, but also a smoothing approach is efficient because the structural measures being adopted are likely to generate a resumption of growth in the future that may itself contribute to the deficit reduction. Hence, it would be unreasonable exclusively to rely on frontloading the fiscal adjustment, especially at a time when the needed removal of distortions is already generating a noticeable net social cost.

The gradual pace of fiscal adjustment announced by the government requires a significant access to debt financing. The 2016 fiscal deficit is estimated at $30 billion, and the borrowing requirement includes an additional $8 billion in debt rollover while payments to holdouts add a lump-sum payment of $12 billion. Given that the domestic capital market is small—partially as a result of the nationalization of the pension system undertaken by the previous government— most of the needed debt financing will have to come from international capital markets. Net of the intra-public sector financing of $11 billion, and an estimated debt issue in the domestic market of $7 billion, borrowing needs for 2016 are estimated at $32 billion. Given the precarious credit rating of Argentina and considering that the total external bond issuance by emerging markets in 2015 was around $75 billion, the committee believes that the government will need to rely on monetary financing by about $12 billion to reduce the amount of external debt issuance to a still large level of around $20 billion. The committee believes that this amount of external financing, though feasible during 2016, will test the limits of Argentina’s access to international capital markets. Thus, the needed monetary financing is consistent with a moderate reduction of inflation, down from a 30 percent level in past three years.

The central bank has announced that its primary objective is to control inflation, phasing out the exchange rate as the nominal anchor. The committee believes that this is a sensible approach because (a) international reserves are low; (b) pass-through coefficients in the region have declined; thus, there seems to be less risk that currency devaluation, for example, would translate into higher inflation, as it was the case in the 1990s; and (c) de-dollarization has significantly reduced balance-sheet risks of exchange-rate volatility. Given this, the committee also believes that the current reliance on sterilization policy with short-term central bank debt at high interest rates runs the risk of creating a snowball effect on debt that may compromise the credibility of the government’s inflation objectives, and destabilize inflation expectations.

In the context of building a sound and credible macro framework, the committee is concerned about the possibility of a sudden increase in the debt issuance in international capital markets by a number of provinces. For example, the province of Buenos Aires has already issued external debt at a very high interest rate and more provinces may follow suit as the holdout problem is resolved.

In the past, fiscal insolvency at the provincial level has adversely affected Argentina’s financial stability. In the 1980s and in the late 1990s, several large provinces issued huge amount of debt (locally and externally) using future proceeds of federal tax sharing as collateral. For example, after the Russian and Brazil’s crises, a number of provinces found themselves unable to fulfill their debt payments, partly because a large proportion of the indebtedness had funded the payment of salaries and other current expenses rather than productive investments. The resulting bailout of the federal government severely complicated Argentina’s fiscal sustainability. These events are still fresh in international investors’ minds, affecting the credibility of Argentina. The committee believes that the federal government and the provinces should approach their access to international capital markets with caution and in a coordinated manner; paying special attention to avoid excessive indebtedness that could jeopardize credibility of the macro program.

A strategy to resume and sustain growth

The strategy to establish credibility not only requires a coherent macro framework but a strategy to boost economic activity and employment. The committee believes that in addition to growth promoting structural measures that produce results in the medium term and are politically difficult to implement (e.g. promoting a more dynamic international integration; strengthening property rights, institutions and governance; reducing the tax burden on the return on capital and investment), the government should prioritize attracting investment to deal with the severe undercapitalization of public services and the lack of an adequate transport infrastructure. This strategy would have three advantages: (a) it would generate an immediate boost to demand, (b) it would create future output capacity and improve productivity, (c) it would create demand for low-skilled labor with consequently positive effects on income distribution. For this to materialize the government needs to ensure that adequate regulatory frameworks for public services and infrastructure—including government procurement procedures—are in place. In the transition, sector-specific legal and financial arrangements to strengthen property rights may help in attracting focused investment projects.

The gradual macroeconomic strategy entails an already significant reliance on domestic and international capital market financing. Therefore, the committee believes the recapitalization of public services and investment in infrastructure projects should rely on multilateral and regional development bank support.

Such support should include creative ways of helping mobilize long-term external and domestic private resources, following examples already underway in other countries. Thus, for example, multilateral development banks may invest in infrastructure funds and private equity funds together with private and institutional investors, as the International Finance Corporation (IFC) is doing through its Global Infrastructure Fund, Inter-American Development Bank through its regional Infrastructure Funds and Development Bank of Latin America (CAF) through sub-regional or national infrastructure funds in several countries in the region (Colombia, México, Peru, Uruguay, Brazil). Further, Multilateral Development Banks may also invest in or partner with national development banks for these and other purposes. Examples include the investment of CAF and IFC in Financiera de Desarrollo Nacional in Colombia and in COFIDE in Peru, the investments of CAF with Banobras and Nafin in their Funds of Funds in México and multiple cases of co-financing programs and projects with such domestic institutions.

The committee supports the government’s announcement that it will normalize relations with the IMF. This will not only contribute to improving Argentina’s access to capital markets but also to facilitate access to official financing from development banks.